RISK
AND OPPORTUNITY
COST OF
CAPITAL
Portfolio Diversification
Diversification by portfolio is time tested and statistically
valid method of managing risk, since in every combination of investment some negative correlation and
risk reduction takes place. Specifically, this means that even though each investment has its own risk
profile, the winds of change that blow through the economic system will impact each investment in a different
way. Therefore, when investments are combined the sum total of risk can be less that the sum of
the individual risks. For example, gold, which is a tangible value, has historically increased in value
in weak economic times, while stocks and other intangible values are dropping in price. Thus an investment
combination of gold and stock presumably provides a "hedge" against change and loss of overall
value. Or to put it another way, an investment in a combination of gold and stock would appear to have
less risk than a total commitment to either investment.
Thus all investment managers, including corporate financial
officers, seek ways of combining investments which will prevent serious loss in many economic scenarios,
including recession, high interest, inflation, etc. and are willing to pay the inevitable "price" for
this protection. The price paid for protection through diversification is the reduced earnings that take
place in that portion of the portfolio being negatively impacted in any scenario. In other words when
paper values such as stocks are rising rapidly, that portion of the portfolio invested in gold is not
doing as well, and therefore weighs against the overall value.
Several mathematical formulas have been developed to measure
combinations of investment for risk reduction purposes. The time tested classics are those centered around
covariance analysis where the year by year experience of two investments is measured to determine
whether, based on every economic scenario, they are positively or negatively covaried. A high positive
covariance would indicate a reduction in risk from combining them, while a negative relationship in their
results would indicate positive risk reduction possibilities. A more advanced mathematical process called
correlation coefficient analysis, will calculate the degree of risk reduction achieved by
various combinations.
Other techniques to evaluate the risk (and thus the price)
of adding an investment to a diverse portfolio have also been developed in recent years. One of these,
the Capital Asset Pricing Model, (CAPM), is widely used to determine the risk of a single investment,
not as a stand alone, but as a risk which of added, may negatively impact the diversified portfolio of
investments one already owns and should, therefore, be priced not by an evaluation of its stand alone
risk, but on the basis of its impact on the portfolio to which it will be added.
In this type of analysis the question is not, What is the
risk of this investment? Rather, it is, How will this investment react with the rest of my investment
portfolio? Sometimes, an investment that would not be selected because of its stand alone risk
will make an ideal negatively correlated risk for other investments being held because it will
provide the necessary hedge against loss.
